Thursday, September 29, 2011

The Sometimes Crazy Pricing Practices of Airlines

The Detroit Free Press ran a front page article last Sunday titled "Hub Premiums Cost Delta Fliers Plenty at [Detroit] Metro Airport" about some of the huge differences in airfares for international travel between Delta Airlines' hub airport in Detroit and its regional spoke airports in nearby Flint, Lansing and Saginaw.

For example, I just checked Delta's website for round-trip travel to Tokyo at the end of October. For first-class travel, the round-trip airfare from Detroit (DTW) on a 3:25 p.m. nonstop flight is $11,606, compared to only $6,324 from Flint, only about 50 miles away. If you fly from Flint you could take a short 20-minute flight to DTW at 1:30 p.m. and join the Detroit passengers on the 3:25 non-stop flight and save $5,282. For travel by coach, you could still save more than $600 by starting in Flint and pay $1,553 round-trip instead of $2,156 from Detroit.

For first-class travel to Amsterdam on Delta, the cost savings starting in Flint would be less, but still almost $1,500 compared to starting in Detroit ($6,304 Flint vs. $7,777 Detroit).

One reason given for more competitive Delta fares at the spokes (Flint, Lansing, Saginaw) than the Detroit hub: Delta accounts for 80% of the passengers at DTW and 91% of international travelers. In contrast, Delta accounts for only 40% of daily flights at the Flint airport, where they compete with AirTran (20% of daily flights), Continental (16%), Frontier (12%) and American (12%). Less (more) competition at the hub (spokes) translates into higher (lower) fares on average.

And the article points out that airlines don't generally price their tickets based on cost (e.g. travel distance), but more on competition (or lack thereof) and "what the market will bear."

Update: Although airline pricing is generally based on "what the market will bear," it seems highly unlikely that the $5,282 difference in airfare to Tokyo between Detroit and Flint (basically a remote suburb of Detroit) can be based on true market pricing, or "what the market will bear." That is, there can't be true market fundamentals that support a $5,000 price difference between two airports that are 73 miles apart. And many people living in the northern suburbs of Detroit like Troy, Rochester Hills and Pontiac would be equidistant from the two airports, and might actually prefer the convenience of the smaller Flint airport than mega-DTW. I predict that some of these significant price differences are unsustainable outliers that cannot persist over time, especially because the crazy, non-market prices have been exposed on the front page of the Detroit Free Press.

Which begs the question. Why is Delta carrying 80+% of the passengers when they are clearly charging so much more than the product costs to deliver?

I suspect it is a question of quality of service. Being a hub point, nearly all the flights out of Detroit are non-stop, a service only Delta can offer (it being their hub and only their hub). If a customer doesn't care about non-stop, they can drive to flint.

Hi Mark -I wrote the following letter about Delta to the editor here in Memphis over a year ago.(3rd letter from the top).http://www.commercialappeal.com/news/2010/jun/24/letters-to-the-editor-thursday/

Are you sure the $6,324 first class fare was roundtrip for a FNT-DTW-NRT one-stop flight? I tried to verify what you found, but had trouble even getting a quote for a FNT-DTW-NRT flight. Their system kept giving me layovers in ATL or SEA or LAX.

Please remember that prices for seats can vary significantly from one passenger to the next. Booking months in advance can often enable one to get much lower fares. Corporate discounts are usually not as low as advanced purchase fares, but often much lower than last week fares offerred to the general public. And corporate discounts vary significantly from one corporation to the next.

Airlines use extremely sophisticated pricing software to manage prices. They are constantly adjusting fares as demand for a specific flight and cabin change in the weeks leading up to departure. Fares are reguilarly adjusted based on activity by competing airlines.

Airlines even raid the bookings of other airlines and offer discounts or perks to specific customers to get them to change.

Bottom line: what you, the general public, can see at an airline's website at any point in time is a very narrow view of what is really going on with fares.

The airlines have us bamboolzed. For all we are led to believe travel around Thanksgiving is horrendous and fares are high. Turns out that the most heavily trafficed days during the year are in the summer and there are 50 of them that beat any other day of the year!

Not sure why you and others seem to have a negative attitude about my industry. But I like to hear the reasons.

Some differences between summer vacation travel and Thanksgiving holiday travel affect the demand for flights and thus the equilibrium price for fares:

1. fliers can generally be much more flexible about dates for summer vacations, but have Thanksgiving holidays fixed by company policies;

2. many vacation fliers make summer flight reservations months in advance in order to ensure availability of cruise ship cabins, resort hotel reservations, etc. Advance booking seems to be not so important for Thanksgiving travelers, and so demand spikes.

3. Occasionally weather situations around Thanksgiving reduce the availability of seats, and the supply reduction increases last minute fare prices.

I'm not doubting that you were able to find a 46% difference for FNT-DTW-NRT and DTW-NRT that includes the same DTW-NRT leg. But I am surprised. Generally such differences occur when an extra stop is required (such as FNT-DTW-ATL-NRT) or when the departure is a different day or significantly different time.

Although I cannot explain your exact circumstance, I do not believe that describing airline pricing as "crazy" is accurate. The airlines have invested many millions of dollars in software which enables them to maximize revenue and profits. Fare differences generally have little to do with cost differences and everything to do with supply and demand. Airlines change prices daily (or even more frequently) in response to demand changes. My experience leads me to believe that, as much as any industry, airlines follow pretty basic economic principles in their pricing practices.

"because the crazy, non-market prices have been exposed on the front page of the Detroit Free Press."

I agree that more information could change the relative demand for FNT- and DTW- originated fligths.

I'm not an economist, so I'm asking a question rather than making a statement:

If imperfect information allowed Delta to charge more for DTW- originated fares, is that an indication of "non-market prices"? Or is there another economics term to describe price variation based on imperfect information?

We had the same problem with Delta here in Cincinnati (CVG). They told us it was because we were a hub. In buying Northwest the hub moved but the high prices stayed. Now several major corporations headquartered here are looking to move to cities with international direct flight service. Not something this market can bear.

John: "Now several major corporations headquartered here are looking to move to cities with international direct flight service"

That's been a big problem for some cities. It's not just the losses of existing company headquarters but also the unseen losses of potential corporate headquarters and U.S. offices of foreign firms. New York, Atlanta, Chicago, Dallas, and Los Angeles should continue to win over cities which have lost major hub status. Not sure yet if Minneapolis and Houston, formerly airline headquarter cities, are feeling the pressure. Houston's energy business is so strong that the city will probably remain a major international gateway.